Investing in ETFs

18 Jan 2018

6 min read

The exchange-traded fund (ETF) has had amazing success as an investment product. Since the first ETF was created, ETFs worldwide have swelled to a record of around US$6.6 trillion ($5 trillion) in assets at the end of June 20171,2.

A background of ETFs

An ETF is an investment fund that holds a basket of securities – such as shares or bonds that tracks a specified index – and is itself a listed share, traded on a stock exchange. ETFs are low-cost, simple vehicles that can offer exposure to a wide range of Australian and global asset classes, indices and sectors, currencies and commodities, as well as a variety of investment strategies. Investors can gain cost-effective, fast exposure to different markets that were once only accessible to institutional investors, including asset classes and strategies through a single investment by buying an ETF. As ETFs are listed, the investment is liquid, and therefore tradable at any time, however like shares, liquidity is dependent on market volumes and during time of significant market stress, liquidity (the ability to buy and sell) could decrease.

ETFs have grown in Australia from the $48 million listing by State Street Global Advisors in 2001 of three funds tracking the S&P/ASX 50 index, the S&P/ASX 200 index and the S&P/ASX 200 Listed Property Trust index, to around $25 billion sector by market capitalisation and there are 217 separate ETFs2,3.

The appeal of ETFs

Typically, ETFs tend to be much cheaper in their annual management costs compared to traditional managed funds. They have no entry or exit fees – investors pay normal brokerage when buying or selling in the same way an investors trades shares. As a note, the price to buy an ETF might be different to the price to sell (much like shares and managed funds) and this is based on a range of things, such as demand.The lower cost of investment in ETFs is an important consideration in the context of long-term investment success, because just as investment returns compound, so do investment fees.

The first generation of ETFs gave investors access to the major share market indices and other asset classes, such as fixed-interest. Second-generation ETFs opened up the opportunity to invest in specific share market sectors, and countries. Third-generation ETFs gave exposure to share portfolios and baskets designed to capture fundamental, ‘factor-based’ or ‘style-based’ strategies in shares. Most ETFs are physical ETFs, in that they actually hold the assets, but “synthetic” ETFs have been created to offer investment in commodities and currencies – these ETFs track their underlying commodities artificially, through derivatives.

ETFs have become so specialised, in Canada there is one devoted solely to medical cannabis stocks: the Horizons Medical Marijuana Life Sciences ETF, which trades on the Toronto Stock Exchange.

The attraction of ETFs is that they are very flexible investment tools, which allow investors to easily improve their portfolio’s diversification; or to easily implement an investment view; or to use investment strategies that were once too complicated or expensive for them to consider. An investor can use ETFs for their entire asset allocation, or they can act as a low-cost complement, or alternative, to existing investments with active fund managers. Some ETFs also appeal to investors through transparency of the underlying investments. This is not true of all ETFs though.

Understanding the risks

Investments carry risk, and ETFs are no exception to this rule. While there is the obvious risk of gain or loss of value depending on market activity, there are other risks to appreciate.

These range from risks specific to the assets the ETF is invested in, to the liquidity of the underlying investments, currency changes should some of the assets be international or even counterparty risk, that is the risk the issuer of the ETF will be unable to fulfil the duties of managing the ETF.

This is not a conclusive list, and investors can find more information about the risks specific to any ETFs they are considering by reading the product disclosure statements offered by the issuers.

Using ETFs in investments

The simplest way in which investors use ETFs is to establish – or diversify – an investment portfolio. For example, an investor who does not own any shares can simply buy an Australian share ETF, giving them a holding in hundreds of Australian shares, in a vehicle that aims to replicate the annual performance of the Australian share market index (give or take some differences in returns due to challenges of copying the index exactly). Adding a global shares ETF to your portfolio can widen this exposure to an international shares allocation; this might add thousands of shares to the portfolio depending on the particular ETF, picking up the world’s top companies (and brands), and tapping into the global revenue streams these generate.

This same investor can then very simply extend the diversification of their portfolio into other asset classes. For example, fixed-income is a great asset class to own, as it provides very sound diversification against shares, but historically it has been a difficult asset class for retail investors to enter, as most types of bonds were sold in prohibitive minimum investment sizes. Effectively, this locked retail investors out of the bond market, unless they wanted to use unlisted bond funds. But fixed-income ETFs offering exposure to investment-grade securities in the Australian commonwealth government and state government bonds arena – as well as the global sovereign (government) and corporate (company) bond market – have opened up the fixed-interest and ‘credit’ asset classes for investments of any amount.

Some advisers use ETFs for their clients in asset allocation, to build portfolios with exposure to specific asset classes like international shares, domestic fixed income, cash and property. The ETFs can also form the “core” holding of a core/satellite portfolio strategy, where the core is held in a low-cost, broadly diversified exposure to an asset class, aiming to earn a return in line with the market’s performance – often referred to as the ‘beta’ return.

Once the core is established, the ‘satellites’ are set up around that: these are typically more specialised investments which the adviser or investor believes will deliver additional returns (alpha). The satellites could be direct shares, actively managed funds, even other ETFs.

ETFs can also be used to gain exposure to a specific investment ‘theme’, as part of a tactical asset allocation process. For example, an investor who believes that the resources sector is poised to out-perform the rest of the Australian share market can tilt their portfolio toward over-weighting the resources industry by buying a relevant ETF. This tilt can be short-term or long-term. Alternatively, an investor who believes that the European economy will grow more strongly than the other developed-world economies could ‘play’ that view by buying a broad European share ETF.

Similarly, an investor who believes that the emerging markets will outperform the developed-world markets could bring an emerging markets ETF into their portfolio, and hold it as long as they believe this outperformance will prevail. Alternatively, this strategy could involve a view on a particular industry: an investor who believes that global spending on healthcare will increase as populations in many countries age – both in the developed and developing worlds – can tap into this theme by buying a global healthcare ETF.

For example, “value” stocks – which are seen as ‘unloved’ companies that have low prices relative to fundamental measurements (such as price/equity ratio, dividend yield or net asset value) – have historically out-performed the broad share market over the long term. Value stocks are those that are out of favour with the market, being priced low, relative to the company’s earnings or assets.

Other common factors include size (market capitalisation), company “quality” (as indicated by a range of fundamental criteria indicating financial health), “momentum” (stocks rising in price) and low-volatility (stocks that historically have fluctuated in price less than the overall index). ETFs based on these factors them can give investors a “smart beta” vehicle through which to make more targeted allocations to potential sources of risk and return, to improve returns, reduce risk or enhance diversification, in both Australian and international shares – and at a lower cost than non-ETF methods of trying to do the same.

Source:
1. The first ETF created was the Toronto Index Participation Fund (TIP 35), in April 1990
2. RBA, The Australian Exchange-traded funds Market Q2 2017
3. Bloomberg

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